Prevention of double deductions of a single loss: solutions in search of a problem

Virginia Tax Review, Summer, 2006 by Douglas A. Kahn, Jeffrey H. Kahn

I. INTRODUCTION

In the current tax system, a corporation is treated as a separate taxable entity. (1) This tax system is sometimes referred to as an entity tax or a double tax system. (2) Since a corporation is a separate and distinct entity from its owners, the shareholders, the default rule is that transfers between them are treated as realization events. Without a specific Internal Revenue Code (Code) provision providing otherwise, such transactions will also require the parties to recognize the realized gain or loss. (3)

Congress has enacted several nonrecognition corporate provisions when forcing the recognition of income could prevent changes to the form of ownership from taking place even if the changes would provide a more efficient and economically beneficial structure. One such provision is section 351, which provides nonrecognition treatment to shareholders who contribute property to a controlled corporation in exchange for corporate stock. (4) When section 351 applies, the shareholder's basis in the corporate stock received and the corporation's basis in the contributed property are calculated to carry forward any realized, but unrecognized gains or losses (subject to certain exceptions described in this article). (5)

Assume, for example, that A, an individual taxpayer, transfers Blackacre, unimproved land, to X Corporation (X) in exchange for 100 shares of X Corporation stock. A's basis in Blackacre is $50,000 and the fair market value of the property is $100,000. Assume A is the sole shareholder of X and therefore the exchange qualifies for nonrecognition treatment under section 351. A's basis in the X Corporation stock received in the exchange is the same basis that A had in Blackacre, $50,000. (6) X takes a transferred basis in Blackacre. X's basis in the contributed property is the same as A's basis at the time of the contribution, so X has a $50,000 basis in Blackacre. (7)

Until fairly recently, this same treatment applied when a shareholder contributed depreciated property. (8) Going back to the example above, assume the property's fair market value is $20,000 and A's basis is still $50,000. For the moment, ignore any specific limitations that apply to this transaction. Ignoring those limitations, A's basis in the X Corporation stock received in the exchange would again be the same $50,000 basis that A had in Blackacre; and X would also take a $50,000 basis in Blackacre. (9)

It is not difficult to understand why some commentators and Congress view this example as abusive. A has used the corporate tax system to create two depreciated assets from one. That is, A took the depreciated asset Blackacre and, through a nonrecognition exchange with X, created the depreciated asset of X Corporation stock while also the corporation kept Blackacre as a depreciated asset. A was able to create two tax losses (the loss that X will recognize when X sells Blackacre and the loss that A will recognize when he sells his X Corporation stock) from one depreciated asset.

In Part V of the article, we explore the question of the extent to which the creation of a double loss should be considered an abuse of the tax system. As our title suggests, we conclude that it is an abuse only in limited circumstances and that Congress has overreacted in prohibiting all duplications of net built-in losses. It would be better to tailor the restrictions to deal with those situations that are abusive. Believing that any duplication of a net loss is an abuse, however, Congress passed several provisions that prevent taxpayers from creating a double net loss. As discussed in detail below, Parts II through IV of the article review the operation of those provisions and illustrate significant problems with their approaches. While those provisions provide useful background material and illustrate the history of congressional attempts to restrict the areas in which double losses can be utilized, a reader interested only in our discussion of why the creation of a double loss often is not an abuse may skip directly to that section of the article.

Prior to 1986, the so-called General Utilities doctrine prevented a corporation from recognizing a gain or loss on the distribution of appreciated or depreciated assets to its shareholders. (10) While most of the General Utilities doctrine was repudiated by amendments made as part of the Tax Reform Act of 1986, a number of inroads to the doctrine had arisen before that date. (11) As a consequence of the 1986 amendments, subject to an exception for the liquidation of a controlled subsidiary, (12) a corporation is required to recognize gain on making a distribution of appreciated property to its shareholders, regardless of whether it was a liquidating or nonliquidating distribution. (13) As to losses realized on a corporation's distribution of a depreciated asset, different treatment is accorded to liquidating distributions than to nonliquidating distributions. A corporation will not recognize a loss on making a nonliquidating distribution of depreciated property. (14) However, subject to limitations, section 336(a) provides that a corporation will recognize a loss on making a liquidating distribution of depreciated property. (15) A corporation realizes a loss on making a liquidating distribution of an item of property in the amount by which its basis in the property exceeds the property's fair market value. The limitations on the corporation's recognition of its realized loss are set forth in section 336(d)(1)-(2). (16) It is a thesis of this article that two of the three limitations imposed by section 336(d)(1)-(2) no longer serve a useful purpose, contravene policies underlying a Code provision adopted more recently, sometimes produces harsh, inappropriate consequences, and so should be repealed. The one remaining limitation of section 336(d)(1) never did serve a useful purpose, so it never should have been adopted.